Balance Sheet Ratio Analysis

Important Balance Sheet Ratios measure liquidity and solvency (a business's ability
to pay its bills as they come due) and leverage (the extent to which the business is
dependent on creditors' funding). They include the following ratios:

Liquidity Ratios:These ratios indicate the ease of turning assets into cash. They
include the Current Ratio, Quick Ratio, and Working Capital.

Current Ratios. The Current Ratio is one of the best known measures of financial
strength. It is figured as shown below:

Total Current Assets

Current Ratio = ____________________
Total Current Liabilities

The main question this ratio addresses is: "Does your business have enough current
assets to meet the payment schedule of its current debts with a margin of safety for
possible losses in current assets, such as inventory shrinkage or collectable
accounts?" A generally acceptable current ratio is 2 to 1. But whether or not a
specific ratio is satisfactory depends on the nature of the business and the
characteristics of its current assets and liabilities. The minimum acceptable current
ratio is obviously 1:1, but that relationship is usually playing it too close for comfort.

If you decide your business's current ratio is too low, you may be able to raise it by:

• Paying some debts.

• Increasing your current assets from loans or other borrowings with a maturity
of more than one year.
• Converting non-current assets into current assets.
• Increasing your current assets from new equity contributions.
• Putting profits back into the business.

Quick Ratios. The Quick Ratio is sometimes called the "acid-test" ratio and is one of
the best measures of liquidity. It is figured as shown below:

Cash + Government Securities + Receivables

Quick Ratio = _________________________________________
Total Current Liabilities

The Quick Ratio is a much more exacting measure than the Current Ratio. By
excluding inventories, it concentrates on the really liquid assets, with value that is
fairly certain. It helps answer the question: "If all sales revenues should disappear,
could my business meet its current obligations with the readily convertible `quick'
funds on hand?"

An acid-test of 1:1 is considered satisfactory unless the majority of your "quick

assets" are in accounts receivable, and the pattern of accounts receivable collection
lags behind the schedule for paying current liabilities.
Working Capital. Working Capital is more a measure of cash flow than a ratio. The
result of this calculation must be a positive number. It is calculated as shown below:

Working Capital = Total Current Assets - Total Current Liabilities

Bankers look at Net Working Capital over time to determine a company's ability to
weather financial crises. Loans are often tied to minimum working capital
requirements.

A general observation about these three Liquidity Ratios is that the higher they are
the better, especially if you are relying to any significant extent on creditor money to
finance assets.

Leverage Ratio:This Debt/Worth or Leverage Ratio indicates the extent to which

the business is reliant on debt financing (creditor money versus owner's equity):

Total Liabilities
Debt/Worth Ratio = _______________
Net Worth

Generally, the higher this ratio, the more risky a creditor will perceive its exposure in
your business, making it correspondingly harder to obtain credit.

Income Statement Ratio Analysis

Gross Margin Ratio:This ratio is the percentage of sales dollars left after
subtracting the cost of goods sold from net sales. It measures the percentage of
sales dollars remaining (after obtaining or manufacturing the goods sold) available to
pay the overhead expenses of the company.

Comparison of your business ratios to those of similar businesses will reveal the
relative strengths or weaknesses in your business. The Gross Margin Ratio is
calculated as follows:

Gross Profit
Gross Margin Ratio = _______________
Net Sales

(Gross Profit = Net Sales - Cost of Goods Sold)

Net Profit Margin Ratio:This ratio is the percentage of sales dollars left after
subtracting the Cost of Goods sold and all expenses, except income taxes. It
provides a good opportunity to compare your company's "return on sales" with the
performance of other companies in your industry. It is calculated before income tax
because tax rates and tax liabilities vary from company to company for a wide
variety of reasons, making comparisons after taxes much more difficult. The Net
Profit Margin Ratio is calculated as follows:

Net Profit Before Tax

Net Profit Margin Ratio = _____________________
Net Sales
Management Ratios:Other important ratios, often referred to as Management
Ratios, are also derived from Balance Sheet and Statement of Income information.

Inventory Turnover Ratio:This ratio reveals how well inventory is being managed.
It is important because the more times inventory can be turned in a given operating
cycle, the greater the profit. The Inventory Turnover Ratio is calculated as follows:

Net Sales
Inventory Turnover Ratio = ___________________________
Average Inventory at Cost

Accounts Receivable Turnover Ratio:This ratio indicates how well accounts

receivable are being collected. If receivables are not collected reasonably in
accordance with their terms, management should rethink its collection policy. If
receivables are excessively slow in being converted to cash, liquidity could be
severely impaired. The Accounts Receivable Turnover Ratio is calculated as follows:

Net Credit Sales/Year

__________________ = Daily Credit Sales
365 Days/Year

Accounts Receivable
Accounts Receivable Turnover (in days) = _________________________
Daily Credit Sales

Return on Assets Ratio:This measures how efficiently profits are being generated
from the assets employed in the business when compared with the ratios of firms in
a similar business. A low ratio in comparison with industry averages indicates an
inefficient use of business assets. The Return on Assets Ratio is calculated as follows:

Net Profit Before Tax

Return on Assets = ________________________
Total Assets

Return on Investment (ROI) Ratio.:The ROI is perhaps the most important ratio
of all. It is the percentage of return on funds invested in the business by its owners.
In short, this ratio tells the owner whether or not all the effort put into the business
has been worthwhile. If the ROI is less than the rate of return on an alternative, risk-
free investment such as a bank savings account, the owner may be wiser to sell the
company, put the money in such a savings instrument, and avoid the daily struggles
of small business management. The ROI is calculated as follows:

Net Profit before Tax

Return on Investment = ____________________
Net Worth

These Liquidity, Leverage, Profitability, and Management Ratios allow the business
owner to identify trends in a business and to compare its progress with the
performance of others through data published by various sources. The owner may
thus determine the business's relative strengths and weaknesses